Marriott Corporation: The Cost of Capital

Background
• As the vice president of project finance at the
Marriott Corporation, we are preparing annual
recommendations for the hurdle rates at each of
the firm's restaurant, lodging and contact services
divisions.
• A hurdle rate of Weighted Average Cost of Capital
(WACC) is used. The selection of investment
projects is based on discounting cash flows by the
suitable hurdle rate for each division.
 Methodology
• The cost of debt (Rd), Cost of equity (Re) and the
capital structure will be determined.
• The WACC can then be calculated when the tax rate is
obtained.
• Risk free rates (Rf), Risk Premium (Rp) and Betas will
all be determined for restaurants and lodging divisions
so that the cost of equity can be determined for the
two divisions.
 Methodology cont’d
• The WACC of the two divisions can be calculated
using the cost of debt and fraction of debt of the
divisions.
• Beta can be found using average method of
identifiable assets of the company
Methodology cont’d
 Cost of Capital
• We measure the opportunity cost of capital for
investments of similar risk using the weighted
average cost of capital (WACC).

• Where D and E are the market values of the debt

and equity, respectively, rD is the pre-tax cost of
debt, it is the after-tax cost of equity, V is the
value of the firm (V = D+ E), and 𝜏 is the corporate
tax rate.
 Cost of Capital cont’d
• Three inputs are required to determine the
opportunity cost of capital: debt capacity, debt
cost, and equity cost of capital consistent with
the amount of debt.
• WACC for the whole company is 7.59% which is
obtained using the following evaluations.
Cost of Capital cont’d
 Cost of Capital cont’d
• It is expected that better and more exact
information is obtained when the time period of
the data is longer.
• This is because they are likely to be free from
factors such as inflation or economic crisis.
• Short term treasury bill returns from 1926 – 1987
for contracts and restaurant services is as the risk
free rate which is 3.54% due to shorter useful
lives of the assets.
 Cost of Capital cont’d
• Long-term U.S. government bond returns from
1926-1987 for Marriot and Lodging is used as the
risk free rate which is 4.58% due to long useful
lives of lodging assets.
• A risk premium of 8.47% is spread between S&P
500 composite return and short-term treasury bill
returns from 1926-1987 for restaurants and
contract services.
 Cost of Capital cont’d
• A premium of 7.43% for Marriot Lodging is the
spread between S&P 500 composite returns and
long-term U.S. government bond returns.
• The cost of debt for Marriot is 10.25%, which is
calculated as the debt rate premium above
government plus 30-year government interest rate.
 Cost of Capital cont’d
• The cost debt for lodging is 10.05%, calculated as
the debt rate premium above government plus 30-
year government interest rate.
• The cost of debt for contract services is 8.3% and
for restaurant is 8.7%, both calculated as debt
premium above government plus 1-year
government interest rate.
 Cost of Capital cont’d
• The average unlevered beta is to calculate the
beta of each division from the formula:
βe =βa + (βa–βd) x [1+(1-t) D/E]
• The companies in the same line of business of
each division have to be chosen first. The equity
beta of those firms are then used to calculate
unlevered beta.
Cost of Capital cont’d
 Cost of Capital cont’d
• The proportion of D/E was from the market value-
target leverage ratios in Table A.
• Then, the cost of capital for the lodging and
restaurant divisions of Marriott is 6.01% and 7.59%
respectively.
summary
 Conclusion
• There is a concern about the correct time interval to
measure these quantities especially given the high
returns and volatility of the bond markets
• The right measure of expected returns to be used is
also a concern; the arithmetic average and the
geometric average.
• With the right historical information, appropriate
variable can be selected an all the quantities be
calculated.
Thank you